What does AIG, an insurance company, have to do with the mortgage meltdown?

Why did we bail out AIG and not Lehman Brothers?

How do we avoid a mortgage-meltdown repeat in the future?

These are just some of the questions being asked and what I think you’ll be surprise to learn is that AIG was not a result of the mortgage meltdown, it was a cause.

Banks have been writing risky mortgages for a long time, at least since Bill Clinton promoted the idea of loosening credit requirements to make home ownership available to more Americans. On the surface, it may have sounded like a good idea, but like an iceberg, the dangers lie beneath the surface.

Once the rules for lending softened, the creative juices of mortgage lenders began to flow resulting in subprime loans, teaser rates, and what some of them called “ninja” loans (No Income, No Job, no Assets). Clearly, these were risky loans, and where there’s risk, there’s a desire for risk-avoidance.

Enter the Credit Default Swap or “CDS.” The media likes to call these “exotic derivatives” and tries to put the blame there. A CDS is nothing more than an insurance policy purchased by a creditor who agrees to pay a periodic premium for the right to collect on the policy if their customer defaults on the loan. So who would write such insurance policies? Insurance companies, of course, and the largest insurance company, AIG, would write the most.

Is there anything wrong with writing a CDS? Only if there’s something wrong with writing an insurance policy on your house or car. However, there is one significant difference between the two. When it comes to your home, since you take a personal interest in protecting that asset, your insurance policy becomes a backstop that you will do everything in your power to avoid collecting on. By comparison, when a bank bundles up a hundred mortgages under one insurance policy, there is no personal association with those assets calling into question whether they care if they default or not since they are covered by a CDS. Also, as with all insurance companies, underwriters need to look at individual policies and decide if the risk of writing the policy is worth taking…apparently, the underwriters at AIG were sleeping at the switch—or maybe “texting at the switch.”

Once mortgage lenders realized they could transfer the risk of ninja loans to AIG for a portion of the premium being paid by their riskiest customers, they also realized that these payments were cutting into their profits. What do you do when your margins get thinned? Easy, make it up in volume!

So by having the ability to dump the risk of bad loans onto AIG, lenders were incented to write as many loans as they could, knowing that they were insulated from defaults! Everyone was making money until the real estate bubble burst and then AIG was left holding the bag unable to pay the claims of their mortgage bank clients. When the music stopped, AIG didn’t have a seat.

Why bailout AIG and not other companies like Lehman Brothers.

First we should be aware that the $85B that is going to AIG is not a gift. It’s a two year bridge loan at 11% interest for which we (the US government) receive 80% ownership of the company. This means that if we (since we are now the owners) are able to turn AIG around, we could make a hefty profit.

Next, we need to consider what would have happened without this loan. If AIG was allowed to go under, they would not have been able to pay the insurance claims made by their customers, the banks who bought these policies to mitigate their risky loans. That would have caused all these banks to go under resulting in a much bigger and diffuse problem. While the world can exist with one less investment banking company (Lehman), it can’t exist without the far-reaching global tentacles of AIG. While I’m not for propping up private companies with public funds, in this case I believe it was the lesser of two evils…but I’m left with the nagging concern: was $85B enough?

What we need to do to avoid this problem in the future.

We obviously need stricter regulations in the mortgage market; ninja loans should not be happening. Also, with proper underwriting, banks would not be able to insure their mortgages as easily and they might be more inclined to scrutinize the loans they make.

Ultimately, we need to recognize the root cause of our economic/security/environmental issues is that $700B is being sucked out of our annual economy for the import of oil, from which we receive choking pollution and fund terrorists who want to kill their customers—primarily us. Fortunately we have the technology available today if we really want to solve the problem, and it would be self-funding. All we have lacked is the leadership in the White House and Congress—my distain is bipartisan—for the last seven years to make it happen.

Imagine the benefit of keeping that $700B within the “friendly confines” of the “US of A” every year where it would wind up as income and savings for our families who would then be able to afford legitimate mortgages.